It was an outcome that not many expected: Infosys Ltd’s stock price rallied 17% on the day it declared its third quarter results. This comes after the stock fell 5.4% and 8.1% on the day it announced its results in the second and first quarters, respectively. Clearly, the company delivered more than expected and even gave a better rupee guidance for the rest of the year, which resulted in the sharp rally in stock price.

But the question really is: how could so many analysts’ earning expectations go wrong for one of the most highly tracked or researched stocks in the benchmark indices? This was clearly the case, else the rally in the stock price post its result announcement would not be justified. With many analysts now changing their recommendation on the stock to a buy and upgrading price targets, it stands confirmed that the earnings took them by surprise. So does such equity research really add value or is it just a shallow resonance of what others are saying?

Do analysts only echo companies’ sentiments?

For many investors who rely on such research, the signal is very confusing. A stock which was till now beaten down by analysts is suddenly in favour. Moreover, the near-term price target has zoomed higher. For example, it was widely reported that global brokerage firm CLSA in October 2012 had suggested that things didn’t look good for Infosys and its stock price could potentially fall 40% in 12 months, but now it has upgraded the price target on the stock to Rs.3,100 (a 12% premium from the current price) changing its underweight stance after 18 months. Most brokerages are saying that the 17% spike in the price on result day is not the end of the rally for this stock.

What went against forecasts was the rather watchful commentary by the management in December. However, taking that on face value and remaining pessimistic on the prospects of the company and hence on the stock price, isn’t research. But that’s where the art of analysis steps in, says Sandeep Singhal, co-head (institutional equities), Emkay Global Financial Services Ltd. “It is hard to pin pointedly pick stocks on downward or upward journey. If you are able to analyse where a stock has made a bottom (in terms of earnings) then a smart investor may start accumulating. Once earnings actually turn, it’s already too late as the market can re-rate the stock very fast.”

Need for more analysis

According to Raamdeo Agarwal, joint managing director, Motilal Oswal Financial Services Ltd, “It’s important to understand how a company functions, what are its competitive advantages and what makes it stand out. Sometimes market behaviour builds in extreme opinion, but the story does not change so fast, only price (market) changes, which makes people change the story.” He added that unless he thoroughly understands the way a company works, the business and the industry it belongs to, he doesn’t invest in a stock. In one portfolio under portfolio management services, he holds 8% in Infosys.

In other words, simply relying on what the management says is not good enough. The analysts need to dig deeper and independently verify the management’s claims. At times, this is not possible. Says Singhal, “In case of Infosys, it operates in the global space and it is difficult for analysts to do a primary check on details and hence one has to rely on management commentary and data from industry associations such as Nasscom.”

Let’s look back at the fraud committed by promoters of Satyam Computer Services Ltd. Most analysts were not able to identify that the company was inflating its profits and thereby the cash balance. One analyst from Kotak Securities Ltd, in a call with the management, did raise a question on high cash balance in the current account, thereby casting the web of suspicion on the company’s bookkeeping.

More recently, Deccan Chronicle’s credit rating was downgraded but only after it failed to pay one lot of redeemable bonds. Now the stock is suspended from trading on the National Stock Exchange. Neither equity nor credit analysis was able to bring out the company’s weak financial health before the damage actually occurred.

These cases clearly point to how much analysts rely on what the management showcases. What they need to ask is: will any company management come forward and declare its woes voluntarily? Which then means that one needs to research beyond the obvious to understand the growth dimension of a company. Says Singhal, “More than management commentary, it is important to interact with customer, intermediaries and employees of the company because if they are happy then in all likelihood the company is doing well.”

What’s amiss?

Focus for equity research needs to be primary from beginning to end. So along with talking to the company, you have to engage with its suppliers, its clients and other stakeholders that can impact earnings. Relying on information given by the company itself and formulating research and projections around that is just a superficial commentary in the garb of research.

Where resources are stretched, historical data can be sought from public sources. But for future projection of earnings, an analyst has to move away, dig deeper into where the clients’ earnings come from. As Agarwal puts it, “The management can only give you information and the rules of the game. Understanding the value they are creating has to be in your mind.”

It is this kind of in-depth research which will distinguish one analyst from another.

The other side of the coin

Equity investing is no longer just about buy and hold, hence analysis also focuses on other aspects. Atul Kumar, senior fund manager-equity, Quantum Asset Management Co. Ltd, says, “With the advent of different strategies such as hedge funds, everyone doesn’t have a long-term price target. So in the near term, there are other factors that can drive price, such as short covering.”

Analysts also rely on intuition, but intuition should be about the management’s ability to deliver long-term growth rather than about whether the stock price will rally in the next three months or not. If most analysts start focusing on fundamental growth, we won’t have a new report on the company every quarter from the same brokerage but with a different price target and recommendation.

What should you do?

For retail investors, equity investing is most effective for a buy-and-hold strategy. If you rely on analyst projections, ask your broker tough questions about their research process. You should be keen to know the history, not just of the company you are investing in but also the analyst who is tracking that company. How long has the person followed the events of the company? Has the analyst traced or researched the sector itself for a long time and how well does she know the competitors’ business?

Adds Singhal, “It is important for individual investors to not look at reports in isolation rather they should consider all reports (across analysts) on the company in totality.”

If this is not the case, then you are better off relying on your own common sense of what social trends are prevalent and what a company can or cannot deliver after reading the information that reports provide. It’s better to stay away from a company whose business you do not understand.